The Issue – Summer 2016
ADVANCED FINANCIAL ANALYSIS
Trends, Comparables, and those pesky KPI’s
By Chris Chillingworth
From the first day of our first business administration classes, we’re taught that Accounting is the language of business. Income statements tell us where we’ve been. Balance sheets tell us where we are. But what tells us where we’re going?
Actually, there are a myriad of tools that not only tell us where we’re headed, but how well we’re doing. Whether you are an investor, a manager (who should be working on behalf of their investor / owners), employee (who work on behalf of management), customer, vendor, or banker, who has a vested interest in whether a company is growing, going to stay in business, or fail, all of these constituent interests rely on tools to assess how a company is doing.
So what are the tools that securities analysts, investors, managers, bankers and others use to assess the health and growth of a company?
“The trend is your friend.” –Anonymous.
Measuring how a particular variable performs over a period of time is one of the key indicators of ongoing performance. Companies often use moving averages of performance in order to smooth out the peaks and valleys that occur when data points are measured on a daily, weekly, or monthly basis.
For instance, in the stock market, it is difficult to spot trends based on daily fluctuations of the price of an individual stock. But average the daily fluctuations over a 50- or 200-day period, and you find a discernable trend. More importantly, you can watch how the 50- day trend compares to the 200- day trend to discern fundamental changes in the direction of a stock price.
Similarly, annualizing a three month revenue trend and comparing it to a 12 month rolling revenue trend will help to identify changes in the overall trend in a company’s revenue.
In all cases, the observer should focus particular attention on trend breakouts and breakdowns, the point at which a particular trend breaks its pattern, in order to understand the “whys” of causation. Understanding the “why” is key to taking action to either sustain the trend on the upside, or mitigate the negative factors on the downside.
Capitalism extolls the virtues of competition. Competition necessitates keeping score. Comparables measure how one company does against another or within its industry. Companies that want to be best-of-breed pay attention to how they are performing against their competitors and in their industry as a whole.
Statistics in the public company arena are relatively easy to come by, as they are published on the SEC and other websites on a quarterly and annual basis for all the world to see.
Obtaining comparables among private companies is a little more difficult, because, as the name implies, they generally keep their data private. However, sometimes industry averages are compiled by Industry Associations, by banks, by credit reporting agencies and by public accounting firms which provide, if not company-specific metrics, then industry-specific metrics.
Comparing a private company’s results to a public company’s results should be made cautiously, due primarily to the disparity in capitalization. Because public companies have, or have had, access to the public market place for raising capital, they tend to have raised, and therefore deployed, substantially more capital than their private company counterparts. Because of the amount of capital they can raise, they also tend to diversify, making direct comparables problematic for a singularly focused private company. In essence, do the best you can to find comparable companies of a similar size and diversification to base comparables on. It would be unfair to compare a singularly focused $50 million private company to a highly diversified $10 billion public company.
Examples of comparable metrics are:
- Revenue growth. Particularly for high technology companies that are prevalent here in the Silicon Valley in which many of us operate, revenue growth is probably the single most important factor in valuing companies.
- Profitability. For most companies, profitability, measured either on its own, or as a ratio of revenue is a measure of the success of a business. Growing profitability is the sign of a healthy business, whereas multiple quarters of negative profitability may be a red flag signaling the company’s inability to stay in business.
- “Free” Cash Flow. Investopedia defines Free Cash Flow (FCF) as “a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base.” It should be noted that it is possible for a company with continuing net accounting losses to be producing positive cash flow, due primarily to non-cash expenditures such as depreciation, amortization, and stock compensation expense, and thus, sustain its ability to stay in business over extended period of time.
Key Performance Indicators (“KPI’s”)
Wikipedia defines a key performance indicator as “type of performance measurement used to evaluate the success of an organization or of a particular activity in which it engages.” In essence, it is a “score” calculated to assist a company in evaluating how it is performing a particular activity. There are literally hundreds of potential KPI’s, some generic to all organizations; some specific to a particular industry. The essential point is to find those indicators, which the organization deems as “key,” that is, finds actionable and measures itself by.
KPI’s can be used by different functions within the same organization. The CEO will have a different set of key performance criteria than, say, the customer service organization. Often, sophisticated financial systems will report these “scores” on computer screen “dashboards” designed to be specific to each manager’s function.
Some of the more common generic KPI’s and their calculations:
- Revenue Growth Rate [Current Period Revenue / Prior Period Revenue minus 1]
- Profitability [Current Period Net Income / Current Period Revenue]
- Return on Equity, “ROE.” [Net Income for a Period / Average Equity for the Period]
- EBITDA, or Earnings before Interest, Taxes, Depreciation and Amortization (a simplified, but universally used metric for Operating Cash flow).
- Days Sales Outstanding, or “DSO’s” a measurement of Receivables collection efficiency
For instance, in the case of DSO’s a reasonable expectation of performance for DSO’s is to approximate the net payment terms offered by a company to its customers. If standard terms are net 30, then one would expect DSO’s to be in the 30 – 35 range. Historically, DSO’s in the 80 – 90 range have been a primary indicator of financial fraud as customers won’t pay for fictitious revenue transactions.
Some KPI’s require the accumulation of non-financial data, such as headcount and the square footage of facilities, which are not traditionally gathered as a part of the company’s standard accounting system. That having been said, some of the more sophisticated accounting systems now capture non-financial data used to calculate certain KPI’s, and report them on the company’s dashboards.
One particular measurement the author likes to use with high tech companies is the engineering dollars spent on sustaining engineering versus new product development spending. Both are grouped together on the income statement under the general caption of R&D, and both must be expensed in accordance with accounting principles generally accepted in the U.S. (GAAP). However, arguably, sustaining engineering is, in essence, maintenance, the cost of keeping the existing product up-to-date. Whereas, new product development could be construed by some, analytically, as an investment in the future, to be recovered from future cash flows. The differentiation of these two metrics will not be apparent from the financial statements, but many companies with significant R&D expense will either have their engineers working in one department or the other, or maintain timecards on projects which can be later summarized into these two categories.
Lenders often use KPI’s in their loan documents as loan covenants, to give them an early warning mechanism to assess when a company’s operating results are inconsistent with the plans they put forward, upon which plans the loan was made. Examples of the types of covenants a lender might include:
- Debt-to-EBITDA ratio. Measures the amount of funded debt to EBITDA, or the amount of debt as a function of the company’s ability to repay that debt from operating cash flow.
- Debt-to-Equity ratio. Measures how much of the total capitalization of the company is represented by debt, as opposed to equity.
- Debt coverage ratio. Measures the company’s EBITDA as a function of its debt service obligations (principle and interest). Ratio should be significantly in excess of 1.
- Current Ratio. Measures the health of the company’s working capital, by dividing current assets (those assets expected to become liquid within one year) divided by current liabilities (those liabilities expected to mature, or come due within one year). Ratio should exceed 1.
- Unrestricted Cash on Hand. Some cash may be restricted, usually pledged to secure some specific obligation such as a line-of-credit, or a standby letter of credit. A bank would want to know what a company’s unrestricted cash-on-hand is, as another measure of the company’s liquidity.
Industry Specific KPI’s
There are many industry-specific KPI’s which are used to compare companies within the same industry to one-another. Examples include:
- Airlines: passenger miles
- Banks and lending institutions: new loan origination
- Customer Service organizations: customer response time
- Freight companies: on time deliveries
- Hospitality: occupancy rates
- IT Systems: system up-time
- Petroleum industry: proven reserves and new exploration
- SaaS companies: new customer acquisition and renewal rates
- Web-based marketing companies: page views and click-thru rates (and more sophisticated measures which allow companies to assess user experience)
There are many others.
Is there a “One Size Fits All” Metric?
Just as the sportswriter Bill James has done in the game of baseball, (as profiled in the book, Moneyball), attempting to reduce the complex statistics maintained in the game, to a single predictive statistic used to spot undervalued players and cobble them together into a pennant-winning team, investors have sought a single statistical variable to measure one company against another. The closest metric we have come up with to date is Return on Investment, or ROI. ROI is one over-riding metric intended to reduce many complex and inter-related events into a single performance metric. Its calculation is the result of dividing “Return” (typically for an annual period) by “Investment.” Investment is typically defined as invested equity PLUS long-term debt. And since Investment adds back long-term debt, Return typically adds back interest expense to put the two metrics on a par with each other.
ROI is intended to level the playing field between companies who borrow heavily with those that don’t, since debt is considered with equity as just another form of capitalization. ROI has the distinction of addressing both operating performance and capitalization in a single metric, which is why it is so highly used.
In order to demonstrate what financial analysis may reveal, which may not be apparent to the reader of just the financial statements, let’s take the case of Spotlight Productions (a fictitious company with no reference to an actual company either stated or implied). Spotlight Productions raised $12.5 million in equity five years ago and is engaged in the business of providing high tech digital imaging equipment to the motion picture industry. The Company purchased $1.5 million in capital equipment in their inaugural year, and has had accelerating growth in revenues typical of many companies in the high tech industry.
Their 5 year Income Statement is presented below:
Let’s pretend that Year 5 doesn’t exist, as yet. Note that the first 4 years reflect increasing net losses and an increasing cash burn. If the first four years were the whole story, an investor might think twice about investing in this company. However, notice that EBITDA losses begin decreasing in the 3rd Year, and when superimposed on a chart graphically with Net Income look something like this:
This chart, plus the increasing margins, with perhaps, management’s discussion of the sales pipeline for Year 5, and the disclosure that a significant portion of their R&D effort was going into new product development, might make for an interesting investment in Year 4.
The traditional financial statements don’t tell the whole story. It is often the trends, comparables, and KPI’s that enhance the reader’s understanding of the quality and direction of the company’s operations. If you would like to learn more about what metrics can do for your company, please contact Chris Chillingworth directly at (408) 309-1343 or e-mail him at firstname.lastname@example.org
 DSO’s can be calculated two ways. The easy way is (Receivables / (Sales for the period / # of days in the period))
However, the correct way is to regressively apply the most recent sales to the receivables balance, until the receivables balance is exhausted, then summarize the number of days accordingly, as follows:
- Receivables $1,500
- Sales (March) $1,000 (31 days)
- Sales (Feb) $1,250 ($500 applied, or 40% of 28 days = 11 days)
- Sales (Jan) $1,500 ($-0- applied)
- Total DSO = 42 days (31+11)
Calculated the “easy” way = 36 days ($1,500 / ($3,750 / 90 days))
 Moneyball, Michael Lewis, W.W. Norton & Co. (c) 2003
Chris Chillingworth is a partner with CFOs2Go Partners specializing in the high tech manufacturing, software, and service industries. He has over 30 years’ experience in financial leadership including multiple roles as a CFO in both the public and private sector.
He leads our financial systems, technical accounting, equity crowdfunding, and corporate governance practice groups.
Partner: Chris Chillingworth Practice Group: Corporate Finance and Transformation, Corporate Restructuring, Financial Planning and Analysis, Financial Systems and Reporting, Technical Accounting and Stock Compensation Topics: accounting systems, Analysis, financial assessments, Handling Finance Opportunities